In January 2001, Tyco’s then-CEO L. Dennis Kozlowski presented his board of directors with a new employment contract stipulating that a felony conviction would not be grounds for his termination. The board signed it without any fuss. Eighteen months later Kozlowski was being investigated for fraud, while Tyco was on the brink of collapse with $32 billion in debt and an $8 stock price.
Kozlowski’s replacement, Edward Breen, promptly set about overhauling Tyco’s board of directors for one simple reason: he knew that in order for the company to survive, return to sustainable success, and to never have this problem again, the company would need board members who asked questions. Kozlowski had spent five years taking Tyco down a path to its own destruction, but at no point did the board ever question his lavish spending, his nearly 600 corporate acquisitions, or even his unusual contract terms. It was this lack of courage, as much as Kozlowski’s excesses and shady dealings, that doomed Tyco.
After all, what is the purpose of a board of directors, if not to provide oversight and guidance to a company’s officers on behalf of shareholders? A board that fails in these duties is every bit as responsible for the company’s demise as the CEO who makes bad decisions.
Unfortunately, establishing a board of directors with the appropriate amounts of intellectual curiosity and courage is somewhat easier said than done. Many CEOs understandably want board members who are supportive and will allow the CEO to run the company as he or she sees fit. But ultimately this is a less effective option for the long term health of the organization.
Board members can come from inside or outside the corporation, and there are pros and cons to both. Board members who come from outside the company are normally less beholden to the CEO and are more prone to critically examining the proposals and decisions of company officers. The downside is that, unfortunately, outside board members also have less information, less context, related to what is happening within the company. To put it another way, they are not as closely in tune with the day-to-day goings on of the business as board members who come from inside the company.
Here in the U.S., the New York Stock Exchange requires that a company’s board be comprised primarily of company outsiders. The reasoning behind this rule is sound, but it is not without its problems. For one thing, while outsider-dominated boards typically provide better monitoring and control, because they have less information than insiders they tend to rely much more heavily on financial controls – which are easier to objectively measure and require less understanding of the business – than on strategic controls. This reliance on financial controls over strategic ones often leads to less reinvestment in the company, and occasionally to over-diversification.
Of course, many companies do not have to worry about the rules of the NYSE. These firms are free to stock their boards with as many company officers as they like, but this can come at a cost as well. While better informed, insider-dominated boards are less likely to critically question CEOs and board chairpersons who also happen to be the company’s majority owner. Owners and chief executives are able to exert a great deal more influence over such a board, so even though the board makes better-informed decisions and is typically more focused on the long term health of the company, some issues don’t get the attention they need because inside board members are also concerned about maintaining a good relationship with their boss.
The best course of action is to have a good mix of both inside and outside board members. This provides a good balance of well-informed members with those who can safely ask hard questions, and enables the board to better balance short term profitability with long term sustainability. The trick becomes keeping the outside members properly informed of the goings-on within the company. With the introduction of Sarbanes-Oxley and a host of other regulatory changes affecting U.S. companies, board members are now flooded with information about the companies they serve, most of it financial. An extremely common complaint from board members today is the difficulty in digesting all of this information and still having time to discuss and make good decisions. Additionally, because there is so much information to sort through, it becomes difficult to spot potential red flags or issues to address within the data.
One partial solution to this problem is to increase the amount of time outside board members dedicate to the company. Some companies have resolved this through the introduction of more frequent meetings. Some require that outside board members spend a portion of their time onsite at various company facilities talking to people and learning about the business. Some provide more frequent updates to the board between meetings.
Another partial solution is to encourage curiosity and critical thinking by the board. Like any other employee, board members can be reviewed based on their performance, and replaced if they do not perform. The use of critical thinking, the willingness to ask tough questions, is something that board members absolutely should be rated on.
And CEOs have to encourage it. None of these suggestions will do any good if the CEO is unwilling to engage in critical discussions and to have their plans potentially torn apart by a board that is just trying to do its job. That’s not an easy thing to do. It requires a strength of character that is not easy to come by. But organizations that can establish this level of courage and intellectual curiosity at the top while finding the right ways to get their board of directors fully engaged will have the potential for a long run of success.